1. What incentives arise for a central bank to fall into the time-inconsistency trap of pursuing overly expansionary monetary policy? Explain the Taylor rule and how the central bank can avoid the problem of dynamic inconsistency by following a Taylor type rule.

2. a) In some countries, the president chooses the head of the central bank. The same president can fire the head of the central bank and replace him or her with another director at any time. Explain the implications of such a situation for the conduct of monetary policy. Do you think the central bank will follow a monetary policy rule, or will it engage in discretionary policy?

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b) In recent years, central banks have dramatically increased the amount of communication with market participants and the public, and at the same time in many of these countries, average inflation has declined and become less volatile. Is this coincidence, or is there a connection? Explain.

3. a) “If countries fix their exchange rate, the exchange rate channel of monetary policy does not exist.” Is this statement true, false, or uncertain? Explain your answer.

b) During the 2007–2009 recession, the value of common stocks in real terms fell by more than 50%. How might this decline in the stock market have affected aggregate demand and thus contributed to the severity of the recession? Be specific about the mechanisms through which the stock market decline affected the economy.


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